A difficult landing ahead

It was exactly a year ago that inflationary concerns began to take hold. In February 2010 inflation surged to 10% from less than 1% a few months earlier and core inflation had begun to nudge up. We had worried that inflation was about to turn sticky. Accelerating growth boosted by large fiscal and monetary stimuli over the previous two years and the absence of any meaningful private investment meant that output gaps were fast closing and core inflation was poised to rise.

The conventional wisdom at the time, however, was quite different. It was all about food inflation. The thinking went as follows: a bad monsoon in 2009 had caused food prices to surge. In turn, high food inflation was largely responsible for pushing up the headline rate. A good monsoon in 2010 would cause food prices to abate sharply and headline inflation would moderate to 6% by December. And all would be well again.

The good monsoon came and went. And yet, a year and rate hikes later we are exactly where we started out. March inflation printed at 9% and will likely be revised up to double digits—exactly the levels observed this time last year. So what went wrong? And how did we get here?

Honey, it’s not just onions

To propose the appropriate policy response, it is important to understand the true underlying drivers of inflation. Equally important, it is important to dispel the myths surrounding inflation.

First, high food inflation is not a new phenomenon and did not start only after the bad monsoon of 2009. Undoubtedly, the drought that year exacerbated the problem, but primary food inflation has been below 6% in India for only seven months in the last five years.

Second, and related, food inflation is not being primarily driven by idiosyncratic supply shocks, but is increasingly structural and broad-based—reflecting rising incomes, changing consumption habits and the inability of supply to keep up. So much was made about onion prices in December and the unseasonal rains that led to it. Yet, a closer inspection of data revealed that onion prices contributed only 60 basis points (bps) to the 13.6% primary food inflation that month. Put differently, if onion inflation was zero in December, primary food inflation would have still been 13% that month. Instead, similar to previous months, food inflation in December was broad-based with all the high protein items showing stubbornly high rates of inflation.

Third, and most importantly, the concern was always about core (non-food manufacturing) inflation rising and turning sticky. In a country such as India, high food inflation inevitably translates into wage inflation. Rising wages and rising raw material prices (as global commodity prices began to surge) in an economy that is increasingly capacity constrained were bound to translate into rising output prices. More generally, with demand continuing to stay high and no significant capacity addition (outside of infrastructure) in the economy over the last three years, it was a matter of time before core inflation rose.

A heated core

That time has come now. What was disturbing (but not unsurprising) in the March inflation print released last week was not just that the headline rate had further accelerated, but that it was the second consecutive month in which manufacturing prices surged. So, even as food inflation has abated in recent weeks, the moderation has been more than offset by rising manufacturing prices. What’s more, the year-on-year inflation rate of non-food manufacturing (7%) is significantly underestimating its sequential momentum, which is actually running at 11% (quarter-on-quarter, seasonally adjusted and annualized).

What’s more, prospects appear sobering. Leading indicators (such as the output price index within the manufacturing Purchasing Manager’s Index, or PMI, survey) suggest that core inflation is likely to accelerate further. This is understandable given that raw material prices continue to rise and output prices have still not fully responded. Further, wage pressures are likely be exacerbated by the indexation of the Mahatma Gandhi National Rural Employment Guarantee Act wages to the consumer price index and the fact that the dearness allowance of Union government employees was recently predictably increased again to compensate for higher inflation.

What’s growth got to do with this?

The preoccupation with food inflation has meant that most of the inflation analysis has strangely avoided discussing the role of growth and closing output gaps in driving inflation over the last year.

The gross domestic product (GDP) growth has accelerated sharply over the last few quarters, staying above 8% for five of the last six quarters and averaging almost 9% in the first half of FY11. More importantly, growth has been boosted by a sustained fiscal and monetary stimulus. Net of asset sales, the Union government’s fiscal deficit rose from 3.1% of GDP to 7.8% of GDP as a result of the large stimulus injected in 2008-09. One would have expected that with growth accelerating to almost 9%, some of the stimulus would have been withdrawn last year. Not to be. Instead, the effective fiscal consolidation (net of asset sales) is expected to be a mere 0.2% of GDP in FY11. The cyclically adjusted fiscal deficit over the last few years shows the same trend with a large stimulus in FY09 and no withdrawal over the last two years.

Monetary policy has been just as culpable. Despite the call rate rising by more than 350 bps over the last year, real interest rates remained negative for most of 2010. The sharp rise in market rates starting in December was more due to tight liquidity in the banking system than due to increases in policy rates. Ironically, market rates rose the most in December despite policy rates remaining on hold that month.

Accelerating growth boosted by multiple policy stimuli is not the problem, per se. What is a problem is that, unlike the West, India does not have any excess capacity and there has been no meaningful private investment outside of infrastructure during this period. Unsurprising, capacity constraints are increasingly binding and output gaps are getting exacerbated. In effect, the policy stimuli has pushed the economy to grow beyond its current potential and core inflation has predictably begun to rise sharply in response.

Any supply response will take time. There is no evidence yet to suggest that a sharp pick-up of the private capex cycle is at hand. And, even if the cycle were to turn on soon, it would take at least three to four quarters before this new capacity comes online.

Therefore, in the near term, slowing aggregate demand is the only real option for policymakers. To expect core inflation to moderate if the economy continues to grow at these rates would be unrealistic. Growth will have to slow to reduce inflationary pressures. The only question is whether it will be a policy-induced soft-landing throughout the year, or a sharp, abrupt hard-landing later in the year.

Budget 2011: too?much?of?a good thing

In all the euphoria surrounding this year’s budget, what was lost was that the FY12 budget effectively targets the largest fiscal consolidation in two decades. To fully appreciate this, it is important to realize that asset sales need to be netted out of revenue to truly assess the extent of fiscal stimulus being injected or withdrawn from an economy. This is because asset sales constitute an exchange of assets between the public and private sector, and thereby do not have any contractionary impact on the private sector.

Viewed through this lens, the budget targets a reduction of the deficit from 6.7% of GDP to 5% of GDP in FY12. A consolidation of this magnitude (occurring primarily through expenditure compression) would have a significant impact on slowing down growth. With most fiscal multipliers in the 0.6-0.7 range (taking into account the crowding in impacts of private investment), if the targeted fiscal consolidation were to be achieved, it would slow growth to between 7% and 7.5%. While this would certainly help bring inflation down, it would, by most accounts generate a hard landing.

Slippages likely

It is unlikely, though, that the budgeted fiscal consolidation would be achieved because subsidies, particularly oil subsidies, seem to have been grossly under-budgeted. The government will likely enter FY12 with arrears to oil marketing companies of about Rs20,000 crore (0.3% of GDP). Even if crude were to average $100 a barrel, the government’s share of the under-recoveries is expected to be around Rs83,000 crore for FY12, and it has only budgeted Rs24,000 crore for this fiscal. Assuming that a similar amount of arrears is rolled over to the next fiscal, the under-budgeting for this fiscal is still about 0.7% of GDP. If crude averages $120, for example, the under-budgeting rises to 1.2% of GDP.

Only significant changes in the administered prices of petroleum products would meaningfully reduce this liability. For example, even if diesel prices are increased by 10% per litre (about a quarter of the under-recovery at $100 a barrel), the government’s liability would only fall by about 0.2% of GDP.

In sum, a fiscal slippage of about 0.6-0.7% of GDP is very likely. This would imply an effective fiscal consolidation of 1% of GDP, and growth slowing to a shade below 8%.

The path ahead?

It is clear growth will need to slow to bring inflation down to more acceptable levels. The only question is whether we are faced with the prospect of a soft or hard landing.

Strangely, FY12 could end with policy slippages on the fiscal and monetary front offsetting each other to accidentally generate a soft landing. The planned fiscal consolidation of 1.7% of GDP looks unrealistic given crude prices and it appears more plausible that the fiscal consolidation achieved would be closer to 1% of GDP.

Monetary policy, in contrast, seems to have been consistently behind the curve and, unless the Reserve Bank of India changes course, is likely to stay that way. However, banking system liquidity is expected to stay tight, keeping market rates high and thereby rendering monetary policy more potency than policy rates suggest.

In sum, even though fiscal and monetary policy are currently on course to be too tight and too loose, respectively, we could end the year with the odd scenario that policy errors offset each other and the economy experiences an accidental soft landing with growth slowing to a shade below 8% and core and headline inflation peaking later this year and gradually moderating thereafter.

Lightning, however, does not strike twice and surely we can’t rely on accidents to bail us out the next time around.